In this article, Pascal Rohner, Katch Investment Group CIO, shares an introduction to Bridge Lending, a growing investment opportunity in the alternative sphere for private investors.
We are in challenging times for financial advisors and private investors. Stock markets have had a good run, fueled by the ongoing strong monetary policies and the economic rebound after the short Covid-19 recession. However, valuation levels appear stretched and it is far from easy to find good value. What is more, traditional fixed income areas remain structurally unattractive. Government bond yields remain close to record low levels, and extra returns for assuming higher risk, such as high yield credit spreads, are at record lows too. And if we consider the moderately rising inflation expectations, real returns are probably in the negative territory, at least for very conservative investors.
It is interesting though, that if we look at private markets, the situation is completely different. Many traditional lenders have been forced to reduce their lending activities after the Great Financial Crisis that unsettled global financial markets and threatened the stability of the banking sector. New regulations caused higher costs of capital and compliance, which led many banks to retreat from lending to small and medium sized enterprises (SMEs) and other niches. The lack of capital for smaller companies is one of the main reasons, why the economic recovery has been so desperately weak over the last 12 years.
The good news is that private lenders, such as specialists alternative asset managers, were able to step up and provide the necessary funding in many niche areas. One of these areas is bridge lending for real estate developers. Bridge lending is typically a short-term loan with a duration of 6-12 months that is fully backed by a charge on a property or land. Traditional banks do not compete in this area of short-term loans such as bridge lending. Their credit underwriting and compliance processes are far too slow in an area where it is all about reputation and speed of executing. Often times, a potential borrower needs funding in less than a month to take an advantage of an opportunity, such as acquiring a property at an auction. Today, to secure a bridge lending solution, a proper credit analyses and debt underwriting must be implemented. Given such a short period of time, it could only be done by specialized private bridge lenders. In some cases, bridge lenders manage their own money, but there are many examples of bridge lenders that are organized as asset managers that manage a pool of private money from private investors, for example via mutual funds.
The emergence of such funds over the last years has created attractive investment opportunities for private investors, with superior risk/return characteristics compared to traditional fixed income investments. Expected returns tend to be much higher, oftentimes in the high single digit area. This can be explained by the scarcity of capital and the short duration of such loans. A potential borrower might be willing to pay a high price if it helps him to secure an attractive investment opportunity, if it is just for a short period of time, i.e. for 6-12 months. If it was for a 10-year fixed-rate mortgage, pricing would be much more sensitive. A recent survey by Ernst & Young in the UK shows that reputation, flexibility, service and speed of executions a more important than pricing for borrowers when choosing the right bridge lending provider.
The other side of the equation that needs to be carefully analyzed by private investors and financial advisors is obviously the risk associated with bridge lending. As mentioned above, the bridge lending activity can be described as a short-term loan that is backed by real estate collaterals, so the risk is generally speaking lower compared to corporate loans that are unsecured. If a bridge borrower misses a payment, the lender can seize the property and sell it in the market, which might help to avoid, or at least reduce, a potential loss.
There are a number of factors that need to be considered when selecting a bridge lending strategy or manager. The most important things are the geographic focus and analyses of the legal system, enforcement regime, liquidity and stability of the real estate market where the bridge lending activity takes place. The UK, for example, is a much better market compared to Italy, for example, in terms of legal system and enforceability. Secondly, private investors need to assess the loan-to-value, or LTV. The ratio shows the average loan size divided by the value of the properties. A lower LTV is preferred, because there is a larger safety cushion in case real estate prices fluctuate. Obviously, a proper analysis and a valuation from an independent real estate valuation company are absolutely imperative to assign a reasonable value and LTV. Thirdly, private investors should focus on portfolios with a high share of 1st lien charges or mortgages. This means that the lender is senior to any other lender. 2nd lien loans, mezzanine and equity bear much higher risk. Duration is also very important. A short duration reduces the market and default risk. It is much easier to get a good visibility on the economic situation, supply and demand factors and other external factors for a period of 6 months, than a couple of years, for example. A shorter duration is oftentimes also associated with less development risk. Short-term loans typically fund acquisitions and short refurbishment projects, while longer-term loans might be used for larger developments.
In conclusion, a carefully selected manager that offers exposure to a diversified portfolio with a conservative approach in terms of the different factors mentioned above, might give private investors access to a very conservative investment portfolio, or investment fund, with relatively low downside risk. At the same time, expected returns are much higher compared to the desperately low yields that many traditional investment areas currently offer.